NOTE: International Finance Discussion Papers are
preliminary materials circulated to stimulate discussion and
critical comment. References in publications to International
Finance Discussion Papers (other than an acknowledgment that the
writer has had access to unpublished material) should be cleared
with the author or authors. Recent IFDPs are available on the Web
at http://www.federalreserve.gov/pubs/ifdp/. This
paper can be downloaded without charge from the Social Science
Research Network electronic library at http://www.ssrn.com/.
You are leaving the Federal Reserve Board's web site. The
web site you have selected is an external one located on another
server. The Board has no responsibility for any external web site.
It neither endorses the information, content, presentation, or
accuracy nor makes any warranty, express or implied, regarding any
external site. Thank you for visiting the Board's web site.www.ssrn.com

Abstract:

Structural reforms that increase competition in product and labor markets are often indicated as the main policy option available for peripheral Europe to regain competitiveness and boost output. We show that, in a crisis that pushes the nominal interest rate to its lower bound, these reforms do not support economic activity in the short run, and may well be contractionary. Absent the appropriate monetary stimulus, reforms fuel expectations of prolonged deflation, increase the real interest rate, and depress aggregate demand. Our findings carry important implications for the current debate on the timing and the design of structural reforms in Europe.

Keywords: Structural reforms, zero lower bound, monetary union

JEL classification: E52, E58, F33, F41

"...the biggest problem we have for growth in
Europe is the problem of lack of competitiveness that has been
accumulated in some of our Member States, and we need to make the
reforms for that competitiveness.

...to get out of this situation
requires...structural reforms, because there is an underlying
problem of lack of competitiveness in some of our Member
States."

José Manuel
Durão Barroso
President of the European Commission
Closing Remarks following the State of the Union 2012
Strasbourg, September 12, 2012

1 Introduction

As the European Monetary Union (EMU) struggles to recover from
the global financial crisis and the European debt crisis,
conventional wisdom among academics and policymakers suggests that
structural reforms that increase competition in product and labor
markets are the main policy option to foster growth in the
region.

This paper is bad news: In a standard dynamic stochastic general
equilibrium model calibrated to match salient features of the EMU
economy, we show that structural reforms do not improve output
during a crisis. In fact, these reforms may entail near-term
contractionary effects when monetary policy is constrained by the
zero lower bound (ZLB). Even more disappointingly, if agents
foresee that such reforms may be reversed (which may quite likely
be the case, as several interest groups have strong incentives to
oppose wide-ranging liberalizations), these policies can generate
large short-term output losses, further deepening the ongoing
recession.

The 2008-9 global financial crisis hit the EMU hard, resulting
in large and widespread output contractions (Figure 1). While core EMU
countries, such as Germany, have mostly recovered their output
losses, the aftermath has been particularly difficult for
peripheral countries (Greece, Ireland, Italy, Portugal, and Spain).
These countries have remained in severe recessions ever since 2008,
eventually triggering doubts about the sustainability of their
public finances and putting in danger the entire Euro project.
Understanding the reasons for this asymmetric response between the
core and the periphery of the EMU and what kind of policies can
address this situation are thus questions of first-order importance
in the current debate.

A popular narrative for the poor performance of the European
periphery is that this reflects the accumulation of "macroeconomic imbalances" since the introduction of the common
currency (see, among others, Eichengreen, 2010; Chen et al., 2012). As shown in the left panel of Figure 2, peripheral
euro-area countries persistently maintained current account
deficits over the past decade, whereas core countries (represented
in the chart by Germany, but Austria and the Netherlands followed a
similar pattern) ran current account surpluses. This steep
deterioration in the periphery's external borrowing position was
associated with sizeable competitiveness losses. As shown in the
right panel of Figure 2, the real
exchange rate of peripheral countries appreciated, relative to
Germany, between 6% (Italy) and 15% (Greece) over the period
2000-2008.2 Importantly, these appreciations
largely reflect outsized increases in non-tradable good prices,
such as housing and other services (see, for instance, Gaulier and Vicard, 2012).

Amid limited policy options, including the impossibility of
devaluing the currency, a broad consensus has emerged: Peripheral
euro-area countries need to urgently adopt structural reforms that
increase competition in product and labor markets. Such reforms
would directly aim at the source of these macroeconomic imbalances,
trying to achieve two complementary objectives in the context of
the current crisis. First, reforms would effectively trigger a "real devaluation" of the periphery relative to the core,
contributing to a reduction in the competitiveness gap accumulated
over the past decade. Second, reforms would boost expectations
about future growth prospects and stimulate current demand via
wealth effects. This view is supported by the extensive empirical
and survey-based evidence pointing to significantly higher economic
rigidities in the periphery. Figure 3, for instance,
presents indexes of economic flexibility obtained from the World Economic Forum (2012) that capture the degree of competition in
product and labor markets.3 Indeed, peripheral countries score
poorly along both dimensions.4 In light of these arguments--and
evidence--it is perhaps not surprising that structural reforms are
the cornerstone of both academics and international agencies'
policy advice, as exemplified in the quote by the President of the
European Commission Jose M.D. Barroso, reported above.

This paper investigates the effectiveness of structural reforms
in an open economy version of the standard New-Keynesian model,
with two sectors (tradable and non-tradable) and two countries that
form a currency union. These two countries differ only in the
extent to which policy barriers grant monopoly power to firms and
unions. Structural reforms in one country (the "periphery" ) are
introduced as a permanent reduction in product and labor market
markups, in line with what is typically assumed in the literature
(see, for instance, Bayoumi et al., 2004; Forni et al., 2010).

In our simulations, the long-run effects of structural reforms
are unambiguously positive. A permanent reduction of product and
labor market markups by 10 percentage points in the periphery
service sector increases the level of output in that region by more
than 5%, with positive spillovers to the core country.5 As
output in the service sector expands and its prices fall, the
periphery experiences a real exchange rate depreciation of more
than 8%. Thus, these figures suggest that ambitious reforms
implemented in peripheral EMU countries could greatly reduce the
income and competitiveness gap observed between core and
periphery.

Notwithstanding these long-run benefits, we find that the
short-run transmission mechanism of these reforms critically
depends on the ability of the central bank to provide policy
accommodation. In normal times, reforms increase agents' permanent
income and stimulate consumption. Amid falling aggregate prices,
the central bank cuts the nominal interest rate and the currency
union experiences a vigorous short-term boom.6 These effects,
however, are completely overturned in crisis times. When the
nominal interest rate is at the ZLB, reforms are contractionary, as
expectations of prolonged deflation increase the real interest rate
and depress consumption. In our simulations, the short-run output
losses associated with the ZLB constraint are increasing with the
magnitude of the reforms and become particularly large when reforms
are not fully credible (and are later undone).

We next consider two experiments in order to disentangle the
short-run transmission of reforms at the ZLB. In the spirit of Eggertsson (2012), we first study the effects of
temporarily granting firms and unions higher monopoly power. In
spite of the absence of long-run changes to output (income effect),
these temporary reforms are expansionary when implemented at the
ZLB. The main intuition for this surprising result is that such a
policy would create inflationary expectations, thus reducing the
real interest rate beyond the direct stimulus provided by monetary
policy and providing incentives to households to front-load their
consumption.

In a second experiment, we follow the recent work by Fernandez-Villaverde et al. (2012) and study the effects of announcements to
credibly implement structural reforms at some future date. This
policy delivers a sizeable income effect thanks to the permanent
increase in the long-run level of output but avoids the short-term
costs of prolonged deflation, as reforms are implemented when the
ZLB stops binding. The net effect is a significant boost in output,
even in the short term.

Our research contributes to a growing literature that studies
the implications of the ZLB constraint for the short-run
transmission of shocks and policies. Eggertsson (2012) argues that New Deal policies facilitated
the recovery from the Great Depression by temporarily granting
monopoly power to firms and unions. Our work differs from his in
two important respects. First, we consider the transmission of
(markup) shocks in an open economy environment which features
tradable and non-tradable goods, thus involving significant
cross-sector and cross-country spillovers. Second, we focus on
shocks that are permanent, emphasizing the horse race between
sizeable increases in long-run income and short-run deflationary
effects. A number of studies have also studied the transmission of
fiscal shocks at the ZLB (see, for example, Christiano et al., 2011; Eggertsson, 2011; Erceg and Linde, 2012), often concluding
that fiscal multipliers change greatly when the central bank's
nominal interest rate is at its lower bound. While we leave a full
investigation of the interaction between structural reforms and
fiscal policy for future research, our findings do suggest that the
magnitude, and possibly the sign, of the structural reform "multiplier" may change as well at the ZLB.7

The rest of the paper is organized as follows. Section 2 outlines a
simplified closed economy model to illustrate the two offsetting
effects that are critical for our evaluation: The perverse effect
of structural reforms due to deflationary expectations, and the
positive effect due to a permanent increase in long-run income.
Section 3 presents the
full two-country model and its calibration. Section 4 discusses the
effects of structural reforms in normal times. Section 5 introduces the
crisis and re-evaluates the effects of structural reforms in that
context. Section 6 studies two
alternative policies that avoid the perverse short-run effects of
structural reforms. Finally, Section 7 concludes.

2 An Illustrative Model

We begin our analysis by studying the effects of structural
reforms in a linearized version of a standard closed economy model
with monopolistic competition and sticky prices. The basic New
Keynesian structure of this model is also at the heart of the open
economy DSGE model that we use in our quantitative experiments.
While we study the full non-linear dynamics of our multi-country
model, the simple intuition that arises from the linearized closed
economy provides insights about the main tradeoffs associated with
structural reforms when monetary policy is constrained by the
ZLB.

The linearized version of the prototype New-Keynesian model can
be summarized by the following two equations

(1)

(2)

where is inflation is output in deviation from its
first best level, is an exogenous
disturbance, is the slope of the Phillips
curve (a convolution of structural parameters), is the coefficient of relative risk aversion,
, where
is the inverse Frisch elasticity of
labor supply, and
is the expectation operator
conditional on all information available at time .
The variable
denotes a wedge between output
under flexible prices and the first best level of output. In the
microfoundation of the model, this wedge could either be driven by
the market power of firms (due to monopolistic competition in
product markets) or markups in the labor markets. We interpret
structural reforms as policies that aim at reducing this wedge by
promoting competition in product and labor markets, for instance
through lower entry barriers in industries, removal of restrictions
on working hours, and privatization of government-owned enterprises
with corresponding increase in the number of operating firms in
protected sectors.

Consider a regime where
that is, the central bank manages
to target zero inflation at all times. Under this assumption, the
model becomes static. In particular, we can think of the short and
long-run equilibrium separately. Denote short-run variables by
and long-run variables by Then, equation (2) reduces to

and

(3)

Equations (3) reveals two
important insights. First, structural reforms have an unambiguous
impact on output, whose magnitude depends on In particular, a reduction in the wedge increases
output. Second, under zero-inflation targeting, aggregate demand
(equation 1) plays no
role in determining short-run output. It is simply a pricing
equation that pins down the level of the interest rate consistent with zero inflation.

The dynamics significantly change when monetary policy is
constrained by the ZLB. Consider the following shock, common in the
literature on the zero bound due to its analytic simplicity: At
time zero, the shock takes value
but then, in each period, it
reverts back to steady state with probability . Once in steady state, the shock stays there forever.
We can consider both long- and short-run structural reforms in this
framework. In particular, consider reforms such that
when the
and
when the shock is back to
steady state (i.e.
). Under these
assumptions, the model can still be conveniently split into long
run and short run by exploiting the forward-looking nature of the
equations. Moreover, as long as
and the policy
is sufficiently
close to the point around which we approximate, the ZLB is binding
only in the short run.

This shock dramatically changes the short-run equilibrium. When
the nominal interest rate is at zero, the economy becomes
completely demand-determined and equation (1) becomes
relevant for the determination of output. Using our assumptions
about the interest rate shock, and taking the solution once the
shock is over as given (which we continue to denote by ), we can rewrite equation (1) and equation
(2) as

Short-run equilibrium at the ZLB under permanent structural reforms in the illustrative model.

Given the policy
the short-run
equilibrium is a pair
that satisfies these
two equations. Graphically, the equilibrium corresponds to the
intersection of the aggregate supply (AS) and the aggregate demand
(AD) "curves," as shown by point A in Figure 4. Note that, when
the ZLB binds, the aggregate demand curve becomes upward-sloping,
as higher inflation stimulates demand through lower real interest
rates.8

Figure 4 shows the
impact of permanent structural reforms (i.e. a reduction in
and
) on short-run output and
inflation. A product or labor market liberalization generates two
effects. First, it shifts the AS curve down, as firms can produce
more output for any given level of inflation. Perhaps somewhat
surprisingly, this effect turns out to be contractionary in the
short run. At the ZLB, reforms amplify deflationary pressures,
resulting in a higher real interest rate and contracting aggregate
demand. Given that the interest rate is stuck at zero, the central
bank cannot provide enough monetary stimulus to offset this effect
and output declines.9

As shown in equation (4), however,
reforms also have a second effect on short-run output
through
, thus shifting the aggregate
demand schedule outward (see again Figure 4). As structural
reforms increase permanent income, output and inflation move up in
the short term as well. Thus, depending on the relative strength of
these two effects, reforms may be contractionary or expansionary in
the short run. For instance, if structural reforms do not have much
"credibility" (i.e. agents expect a policy reversal at some
point in the future, such that
but
), the AS curve shifts down
whereas the AD curve does not change, and the reforms are clearly
contractionary (point B in Figure 4). In contrast,
ambitious reforms that are gradually implemented and become more
credible over time are associated with large permanent income
effects, shifting the AD curve more than the AS curve (point C in
Figure 4).

The question of which effect dominates is ultimately
quantitative. For this purpose, in the next section, we develop and
calibrate a two-country model of a monetary union that we then use
as a laboratory to evaluate the effects of different structural
reforms experiments.

The open-economy dimension of the model is important to make our
analysis concrete with respect to two key features that are
relevant for the debate on the European crisis. First, the evidence
in Figure 3 suggests that structural reforms are mostly needed in the
periphery, to favor a catch-up in competitiveness with the core.
Second, and related, structural reforms may prove helpful in
closing the imbalances in external borrowing and relative prices
that have received so much attention since the onset of the crisis.
Our analysis sheds light on the short-run interaction between the
role of structural reforms in correcting these imbalances and
monetary policy when the nominal interest rate is constrained by
the ZLB.

3 The Full Model

The world economy consists of two countries, the periphery
() and the core (), that belong
to a currency union whose population size is normalized to one. The
common central bank sets monetary policy for the union targeting
zero inflation.

A continuum of households of measure inhabits
country . Each household derives utility from
consumption of tradable and non-tradable goods and disutility from
hours worked. Households supply sector-specific differentiated
labor inputs. A representative labor agency combines these inputs
in sector-specific aggregates, while households set the wage for
each input on a staggered basis.

Firms in each country produce tradable and a non-tradable goods
using labor, which is immobile across countries. Production takes
place in two stages. In each sector (tradable and non-tradable), a
representative retailer combines differentiated intermediate goods
to produce the final consumption good. Monopolistic competitive
wholesale producers set the price of each differentiated
intermediate good on a staggered basis.

In each country, we assume the existence of a full set of
transfers that completely insure against the idiosyncratic income
risk arising from staggered price and wage setting. Across
countries, the only asset traded is a one-period nominal bond
denominated in the common currency. One-period changes in the net
foreign asset position define the current account.

This section presents the details of the model from the
perspective of the periphery (country ). Variables
for the core (country ) are denoted by an
asterisk.

3.1 Retailers

A representative wholesale producer in the tradable () and non-tradable () sector combines
raw goods according to a technology with constant elasticity of
substitution

(6)

where indexes an intermediate goods producer and
is the size
of the tradable and non-tradable sector, respectively.

The representative retailer in sector
maximizes profits subject to its technological constraint (6)

(7)

The first order condition for this problem yields the standard
demand function

(8)

where is the price of the variety of the good produced in sector .
The zero profit condition implies that the price index in sector
is

(9)

3.2 Labor Agencies

In each sector, a representative labor agency combines
differentiated labor inputs provided by each household into a sector-specific homogenous aggregate
according to a technology with constant elasticity of substitution

where is the wage index in sector
and is the wage
specific to type- labor input. The first order
condition for this problem is

(12)

The zero profit condition implies that the wage index is

(13)

3.3 Intermediate Goods Producers

A continuum of measure
of intermediate goods producers
operate in each sector using the technology

(14)

where is an exogenous productivity shock.

Intermediate goods producers are imperfectly competitive and
choose the price for their variety , as
well as the optimum amount of labor inputs ,
to maximize profits subject to their technological constraint
(14) and the demand
for their variety (8).

As customary, we can separate the intermediate goods producers
problem in two steps. First, for a given price, these firms
minimize labor costs subject to their technology constraint. The
result of this step is that the marginal cost (the Lagrange
multiplier on the constraint) equals the nominal wage scaled by the
level of productivity

(15)

This condition also shows that the marginal cost is independent of
firm-specific characteristics. However, because of nominal price
and wage rigidities, aggregate labor demand in each sector depends
on price dispersion. We can use the demand function (8) and the
production function (14)
to write an aggregate production function as

(16)

where equilibrium in the labor market implies

and
is an index of price dispersion
defined as

The second step of the intermediate goods producers' problem is
the optimal price setting decision, given the expression for the
marginal cost. We assume that firms change their price on a
staggered basis. Following Calvo (1983), the
probability of not being able to change the price in each period is
. The optimal price setting
problem for a firm that is able to reset its
price at time is

(17)

subject to the demand for their variety (8) conditional on
no price change between and .
Households in each country own a diversified non-traded portfolio
of domestic tradable and non-tradable intermediate goods producing
firms. Therefore, firms discount future profits using --the individual stochastic discount factor for a
nominal asset between period and period
(such that ).
The time-varying tax
is the policy instrument that
the government can use to affect the degree of competitiveness in
each sector. Ceteris paribus, a lower tax reduces the firms'
effective markup and increases output. We discuss government policy
in more details below.

In equilibrium, all firms that reset their price at time
choose the same strategy (
).
After some manipulations, we can write the optimality condition
as

(18)

where
is the
inflation rate in sector . Firms that are not able to
adjust, on average, keep their price fixed at the previous period's
level. The price index (9) for sector
yields a non-linear relation between the
optimal relative reset price and the inflation rate

(19)

Moreover, from the price index (9) and the
assumption of staggered price setting, we can also derive the law
of motion for the index of price dispersion

(20)

In steady state, there is no price dispersion (
) and the price in sector
is a markup over the marginal cost

(21)

The government can choose a value of
that fully offsets firms'
monopolistic power--or, more generally, set a desired markup level
in the goods market.

3.4 Households

In country , a continuum of households of measure
derive utility from consumption and supply
differentiated labor inputs while setting wages on a staggered
basis (Calvo, 1983). Consumption is a composite of
tradable and non-tradable goods with constant elasticity of
substitution

(22)

where
is the share of tradables
in total consumption. The associated expenditure minimization
problem is

(23)

subject to (22). The first
order condition for this problem yields the demand for the tradable
and non-tradable goods

(24)

(25)

The associated price index is

(26)

Consumption of tradables includes goods produced in the two
countries combined according to a constant elasticity of
substitution (
) aggregator

(27)

where
is the share of tradable
goods produced in country . We assume that
the law of one price holds for internationally tradable goods

(28)

(29)

The expenditure minimization problem is

(30)

subject to (27). The first
order conditions for this problem yield the standard demand
functions for tradable goods

(31)

(32)

The zero profit condition implies that the price index for tradable
goods is

(33)

While the the law of one price holds, home bias in tradable
consumption () implies that the price
index for tradable goods differs across countries (
). Consumer price
indexes (CPI) further differ across countries because of the
presence of non-tradable goods. Therefore, purchasing power parity
fails (
) and the real
exchange rate (
) endogenously moves.

Conditional on the allocation between tradable and non-tradable
goods and between tradable goods produced in country and , the problem of a generic household
in country
is

(34)

subject to the demand for labor input (12) and the budget
constraint

(35)

where represents nominal debt,
indicates profits from
intermediate goods producers and
represents lump-sum
tranfers. As for the goods market, the sector-specific and
time-varying tax
is the policy instrument that
the government can use to affect the degree of competitiveness in
the labor market of each sector. Ceteris paribus, a lower tax
reduces workers' monopoly power and increases labor supply. The
variable
is a preference shock that
makes agents more or less impatient. For instance, positive
preference shocks (an increase in the desire to save) may capture
disruptions in financial markets that force the monetary authority
to lower the nominal interest rate to zero. Finally, as in Erceg et al. (2006), the intermediation cost
ensures stationarity of the net
foreign asset position

(36)

where
and
corresponds to nominal GDP

(37)

Only domestic households pay the transaction cost while foreign
households collect the associated fees. Moreover, while we assume
that the intermediation cost is a function of the net foreign asset
position, domestic households do not internalize this
dependency.10

The existence of a full set of transfers that completely insure
against the idiosyncratic income risk arising from staggered price
and wage setting and an appropriate normalization of initial wealth
levels implies that all households make the same consumption and
savings decisions (
,
). Hence, from now
on, we will suppress the index from consumption
variables. The consumption-saving optimality conditions yield

(38)

From expression (38), we
can denote the stochastic discount factor for nominal assets
() as

(39)

Each household has a probability of being able to reset the wage
at time equal to . The
optimal wage setting problem in case of adjustment for household
working in sector is

(40)

subject to the demand for the specific labor variety (12) conditional on
no wage change between and .

In equilibrium, all households who reset their wage at time
choose the same strategy (
).
After some manipulations, we can rewrite the first order condition
for optimal wage setting as

(41)

where
is the
wage inflation rate in sector . The remaining
households, who are not able to adjust, on average keep their wages
fixed at the previous period's level. The wage index (13) for sector
yields a non-linear relation between the
optimal relative reset wage and the wage inflation rate

(42)

In steady state, the real wage in sector is a
markup over the marginal rate of substitution between labor and
consumption

As in the case of prices, the government can choose a tax that
fully offsets workers' monopolistic power--or, more generally, set
a desired markup level in the labor market.

3.5 Fiscal and Monetary Policy

We assume that the government in each country rebates goods and
labor market taxes via lump-sum transfers

(43)

Using (37) and its
foreign counterpart, we construct a union-wide level of output as a
population-weighted geometric average of the levels of output in
the two countries

(44)

In the same spirit, we define the union-wide price index
as a population-weighted
geometric average of the CPIs in the two countries11

(45)

Consequently, the inflation rate in the currency union is

(46)

We assume that a single central bank sets the nominal interest
rate in the entire union to implement a strict inflation target

However, we take explicitly into account the possibility that the
nominal interest rate cannot fall below some lower bound

In the aftermath of shocks that take the economy to the lower
bound, the central bank keeps the nominal interest rate at
until inflation reaches its target
again. Our results would be unchanged if we were to specify an
interest rate rule that responds to inflation, the output gap
and/or the natural rate of interest.

3.6 Equilibrium

An imperfect competitive equilibrium for this economy is a
sequence of quantities and prices such that the optimality
conditions for households and firms in the two countries hold, the
markets for final non-tradable goods and for labor inputs in each
sector clear at the country level, and the markets for tradable
goods and financial assets clear at the union level. Because of
nominal rigidities, intermediate goods producers and workers who
cannot adjust their contracts stand ready to supply goods and labor
inputs at the price and wage prevailing in the previous period. An
appendix available upon request contains the detailed list of
equilibrium conditions. Here we note that goods market clearing in
the tradable and non-tradable sectors satisfies

(47)

(48)

(49)

(50)

Integrating the budget constraint across households in country
and using the zero profit conditions for
labor agencies and retailers, as well as the government budget
constraint and the equilibrium conditions for tradable and
non-tradable goods, implies that net foreign assets evolve
according to

(51)

Finally, asset market clearing requires

(52)

3.7 Calibration and Solution
Strategy

In our experiments, we model structural reforms as changes in
the tax rates
and
that affect, permanently or
temporarily, the markups in the labor and product markets (i.e. the
degree of competition in the two markets). We run deterministic
non-linear simulations that allow us to quantify the steady state
effects and trace the dynamic evolution of the endogenous variables
in response to the policy experiment.12

We set the initial levels of price markups in the periphery and
the core following the estimates produced by the OECD (2005) for
peripheral and core EMU, reported in Table 1. We consider the
manufacturing sector as a proxy for the tradable sector in the
model and the service sector as a proxy for the non-tradable
sector. The OECD estimates for price markups show two interesting
patterns. First, markups in the periphery are higher than in the
core, consistent with the evidence provided in Figure 3. Second, this
difference is largely accounted for by higher markups in the
service sector of the periphery, whereas markups in the
manufacturing sector are similar across regions. These data support
the view that peripheral European countries could greatly benefit
from the implementation of liberalization measures in the product
market.

In order to calibrate the elasticity of substitution in sector of each region, we start
from the expression of the total markup in the steady state

(53)

For the manufacturing sector, we assume symmetry across countries
and no policy-induced distortions (i.e.
).
Targeting a steady state net markup of 15%, this
strategy allows us to pin down the elasticity of substitution in
the tradable sector (
). For
the service sector, we assume no policy distortion in the core (
). The estimate in Table 1 then implies
. We assume that the
elasticity is the same in the periphery (
) and
attribute the difference in the OECD markup estimates to policy
distortions (
).

Empirical studies point to similar patterns for wage markups
across countries and sectors. Although direct estimates of wage
markups are more difficult to obtain, data on wage premia (Jean and Nicoletti, 2002) and evidence on wage bargaining power
in Europe (Everaert and Schule, 2006) indicate that
wage markups are likely to be higher in peripheral countries than
in core countries because of higher markups in the service sector.
Furthermore, the point estimates of the implied wage markups so
computed are not too different from the figures presented in Table 1. Thus, we
set the wage elasticities and taxes across sectors and regions
equal to the corresponding values for the product market.13

Table 2. Parameter Values

Parameter

Value

Households: Country size

= 0.5

Households: Individual discount factor

= 0.99

Households: Inverse Frisch elasticity

= 2

Households: Elasticity of intertemporal substitution

= 2

Households: Home bias

= 0.57

Households: Consumption share of tradable goods

= 0.38

Households: Elasticity of substitution tradables-nontradables

= 0.5

Households: Elasticity of substitution H-F tradables

= 1.5

Price and Wage Setting: Probability of not being able to adjust prices

= 0.66

Price and Wage Setting: Probability of not being able to adjust wages

= 0.66

Monetary Policy: Inflation target

= 1

Monetary Policy: Effective lower bound on nominal interest rate

= 0.0025

The remaining parameters used in our simulations are relatively
standard (Table 2). In our benchmark experiment, the core and the periphery have the
same size (). The individual discount factor
equals 0.99, implying an annualized
real interest rate of about 4%. The coefficient of relative risk
aversion is equal to 0.5, which is within the
range of estimates provided in Hansen adn Singleton (1983) and slightly higher than Rotembert and Woodford (1997). The inverse Frisch elasticity
is equal to 2, a value commonly used in
the New-Keynesian literature (see, for instance, Erceg and Linde, 2012). We calibrate the degree of home bias
and the size of the tradable
sector
to match (i) a steady state
import share of 15% (corresponding to the average within-eurozone
import share for France, Germany, Italy, and Spain) and (ii) a
steady state output share of 38% in manufacturing (from the
EU-KLEMS database). We set the elasticity of substitution between
tradable and non-tradable goods equal to
0.5, consistent with the estimates for industrialized countries in Mendoza (1991), and the elasticity of substitution
between tradable goods produced in the core and in the periphery
to 1.5, as in Backus et al. (1994). Finally, the probabilities of not being able to
reset prices and wages in any given quarter ( and , respectively) equal
0.66, implying an average frequency of price and wages changes of 3
quarters. We assume that the ECB targets zero inflation (
) and consider an effective lower
bound of the short term interest rate of 1%, annualized consistent
with the evidence that the ECB has been resistant to lower nominal
rates below that threshold throughout the crisis.14

4 The Effects of Structural Reforms in
Normal Times

We begin our analysis by investigating the consequences of
structural reforms in normal times. Specifically, we study the
effects of a permanent reduction in the tax component of
steady-state price and wage markups by one percentage point in the
periphery non-tradable sector. Figure 5 presents the
dynamics of the main economic variables following the
implementation of these reforms.

In response to lower markups in the non-tradable sector,
peripheral output sharply expands on impact and subsequently
decreases before converging to a higher long-run steady state
(top-left panel). Trade linkages between the two regions of the
monetary union propagate this expansion in the periphery through
higher demand for goods produced in the core, thus stimulating a
large short-run increase of output in the core. Overall, output in
the monetary union expands almost 2.5% in the near term and the
price level declines a touch, as deflation in the periphery
outweighs the modest demand-driven increase of prices in the core
(top-right panel). Crucially, the common central bank accommodates
the effects of structural reforms by lowering policy rates
(bottom-left panel).

As for developments across sectors, lower markups in the
non-tradable sector generate a sizeable short-term increase of
non-tradable and tradable output in the periphery as well as in the
core country (middle-left panel). Lower markups also induce a
decline of non-tradable prices but an increase in the price of
tradable goods as well as of prices indices in the core country
(middle-right panel). International relative prices in the
periphery depreciate, but most of the movement in the real exchange
rate (
) is accounted for by
changes in the relative price of nontradables, whereas changes in
the terms of trade (
) are
comparatively small (bottom-right panel). The same panel also shows
that the current account (
, where
) responds little to
structural reforms, as permanent changes in the income of the
periphery reduce the incentive to smooth consumption through the
trade balance.

In the long run, this one-percentage point reduction in price
and wage markups implemented by the periphery increases domestic
output by 0.56%. This gain mostly reflects the permanent expansion
of production in the non-tradable sector. Notwithstanding the
modest size of the reforms considered, measures of competitiveness
typically observed by policymakers improve substantially, with the
real exchange rate in the periphery depreciating by 0.85% in the
long run. The relative price of nontradables drives the
depreciation, whereas the terms of trade only accounts for about
20% of the total adjustment in the real exchange rate.

While the dynamics explicitly take into account the
non-linearities of the model, the steady state effects are
approximately log-linear. Therefore, the numbers just reported can
be interpreted as elasticities. For example, permanent reduction in
markups by 10 percentage points increases output in the domestic
country by about 5.5% and depreciates its real exchange rate by
about 8.5%. This finding, which is consistent with other studies in
the literature (Bayoumi et al., 2004; Forni et al., 2010), supports the policy prescription that higher
competition in product and labor markets can generate sizable
permanent gains in peripheral countries'output, possibly boosting
their near-term growth prospects as well through substantial wealth
effects.

5 The Effects of Structural Reforms in
a Crisis

We next investigate how the short-run transmission mechanism of
structural reforms changes in the presence of the ZLB constraint.
The motivation for this analysis is twofold. First, a legacy of the
2008-09 global financial crisis is that policy rates have been at
the ZLB in many countries for several years. This development has
prompted a large debate on the role of alternative policies at the
ZLB, the impact of the ZLB on the recovery, and the ability of
monetary policy to deal with unexpected adverse events (such as the
European debt crisis). Second, a growing literature finds that the
effects of shocks in the presence of the ZLB can be qualitatively
and quantitatively very different than in normal circumstances. For
instance, Erceg and Linde (2012) find that tax-based
fiscal consolidations may entail lower output losses in the short
run than expenditure-based fiscal consolidations, thus overturning
findings previously established in the literature (see, for
instance, ALesina and Ardagna, 2010). Closer to our
work, Eggertsson (2012) argues that a temporary
increase in the monopoly power of firms and unions helped the U.S.
recovery during the Great Depression by relaxing the ZLB constraint
on monetary policy. This result is in contrast with the
conventional wisdom that these policies increased the persistence
of the recession (see, for instance, Cole and Ohanian, 2004).

In our crisis scenarios, we follow the recent literature (see,
for example, Eggertsson and Woodford, 2003) and assume that an
aggregate preference shock hits the monetary union, depressing
output and generating deflation. The common central bank attempts
to provide monetary stimulus, but the ZLB constraint prevents it
from completely offsetting the recession.

Figure 6
displays the impact of the crisis. We calibrate the size of the
shock so that we can reproduce the peak-to-trough decline of
euro-area output of about 4% following the collapse of Lehman
Brothers in September 2008 (top-left panel). Interestingly, under
our baseline calibration, prices drop nearly 1% (top-right panel),
in line with the data. The central bank immediately cuts the
nominal interest rate to its effective lower bound of 1% and keeps
this accommodative stance for 10 quarters (bottom-left panel). The
crisis' deflationary pressures, combined with the lower bound
constraint, imply that the real interest rate remains relatively
high (bottom-right panel).15

Having described the crisis environment, we next study the
response of the economy to structural reforms considered in Section 4.

5.2 The Effects of Structural Reforms at
the ZLB

Table 3: Impact effects of structural reforms at the ZLB

(in p.p.)

Output

Inflation

Real Rate

0

-4.00

-0.93

1.86

1

-4.13

-1.47

2.22

5

-4.56

-3.59

3.56

10

-5.07

-6.25

5.13

Note: Response (in %) to a permanent reduction in price and wage markups in the periphery non-tradable sector.

Table 3 summarizes the main findings of our analysis. As shown in the first
column, we consider permanent structural reforms in the periphery's
non-tradable sector ranging from no change in labor and product
market markups (crisis scenario) to a 10 percentage point reduction
in both markups (crisis scenario + ambitious reforms). The last
three columns of the table present the impact response of
union-wide output (second column), prices (third column), and the
real interest rate (fourth column) to these policy experiments.
Amid contracting output and falling prices due to the crisis, the
implementation of reforms in a ZLB environment further reduces
aggregate output between 13 basis points (in the case of a 1
percentage point markup reduction) and 1.07 percentage points (in
the case of a markup reduction of 10 percentage points).

The fall in periphery output primarily explains the union-wide
contraction. In the periphery, production collapses both in the
tradable and non-tradable sector. As marginal costs decrease, firms
in the non-tradable sector cut prices, thus worsening the
deflationary pressures associated with the crisis and contributing
to an increase in the real interest rate. This effect slows down
demand even further, with consequences also for the tradable
sectors of both countries. Conversely, core aggregate production is
roughly unchanged. In that region, the slowdown in tradables is
approximately compensated by an increase in the production of
nontradables, driven by a favorable adjustment in relative
prices.

The short-run perverse effects of reforms are quantitatively
even more remarkable when compared to the standard effects of
reforms in normal times. A markup reduction by one percentage point
generates an increase in union output of about 2.5% in normal times
(see Figure 5
above), but an output drop of 13 basis points in a crisis. This
change in the sign of the output response suggests that the
short-run transmission of structural reforms critically depends on
the ability of monetary policy to provide stimulus. When the ZLB
constrains monetary policy, the income and substitution effects of
reforms may work in opposite directions. On the one hand, agents
anticipate that income will be permanently higher, resulting in
strong wealth effects and higher consumption. On the other hand,
these policies stimulate production and competitiveness through
lower domestic prices that result in higher real interest rates.
While in normal times the central bank accommodates deflation by
reducing the policy rate, higher real rates at the ZLB further
depress consumption and output. Not surprisingly, more ambitious
reform efforts are associated with a deeper output contraction as
deflationary pressures become even more acute.

Figure 7: Effects of Reforms in Crisis

Response of output (top-left), inflation (top-right), nominal interest rates (bottom-left) and real interest rate (bottom-right) to the crisis without reforms (continuous black line) and with a permanent increase in labor and product market subsidies by one percentage point (dashed blue line).

Data for Figure 7

GDP

Inflation

Nom Int Rate

Real Int Rate

1

0.00

0.00

4.04

4.04

2

-4.14

-1.47

1.00

2.22

3

-3.07

-1.21

1.00

1.98

4

-2.20

-0.98

1.00

1.79

5

-1.52

-0.78

1.00

1.63

6

-1.00

-0.62

1.00

1.51

7

-0.63

-0.50

1.00

1.42

8

-0.38

-0.41

1.00

1.35

9

-0.23

-0.35

1.00

1.31

10

-0.18

-0.31

1.00

1.29

11

-0.22

-0.29

1.17

1.44

12

-0.25

-0.27

1.37

1.62

13

-0.25

-0.25

1.53

1.76

14

-0.23

-0.24

1.67

1.89

15

-0.21

-0.22

1.79

2.00

16

-0.19

-0.21

1.91

2.11

17

-0.17

-0.20

2.01

2.21

18

-0.15

-0.19

2.12

2.30

19

-0.13

-0.18

2.21

2.39

20

-0.11

-0.17

2.30

2.47

Granted, the long-run benefits of structural reforms remain
unchanged, and union-wide output improves relative to the crisis
after a few quarters (Figure 7). Yet, in the
short run, structural reforms do not contribute to alleviate the
consequences of a deep crisis. The main point of the paper, on
which we elaborate in the next section, is not to deny the
long-term gains associated with these reforms. In contrast, our
analysis underscores that, absent the appropriate monetary
stimulus, ambitious reforms may be detrimental for the near-term
growth prospects of vulnerable euro-area countries, contrary to
what is often advocated in policy and academic environments.

5.3 The Effects of Temporary Reforms at
the ZLB

Under our baseline calibration (as well as in several robustness
checks discussed in the next subsection), permanent reforms at the
ZLB do not contribute to support economic activity in the immediate
aftermath of a demand-driven crisis. In practice, other
impediments--such as social unrest, political economy
considerations, reallocation of factors across sectors, uncertainty
about the implementation and gains of reforms--may actually
exacerbate the short-term costs of reforms and limit their
long-term benefits. The Greek and Spanish strikes over the recent
austerity measures, as well as the pledge of some parties to undo
the labor market reforms undertaken by the technocratic government
during the 2013 elections in Italy, are clear examples of these
issues.

We model these complex socio-political dynamics by considering
an experiment in which the reforms are perceived as (and in fact
turn out to be) temporary. Governments in the periphery implement
labor and product market reforms as the crisis hits. However, the
short-run costs in terms of deflation and the absence of output
gains lead to social unrest and imply that the reforms are
eventually undone. We make the simplifying assumptions that this
outcome is perfectly anticipated at the time of implementation and
the reforms are unwound when the ZLB stops binding.16

Figure 8: Effects of Temporary Reforms in Crisis

Response of output (top-left), inflation (top-right), nominal interest rates (bottom-left) and real interest rate (bottom-right) to the crisis without reforms (continuous black line) and with a temporary increase in labor and product market subsidies by one percentage point (dashed blue line).

Data for Figure 8

GDP

Inflation

Nom Int Rate

Real Int Rate

1

0.00

0.00

4.04

4.04

2

-7.37

-2.50

1.00

3.20

3

-5.88

-2.18

1.00

2.87

4

-4.62

-1.86

1.00

2.57

5

-3.58

-1.56

1.00

2.30

6

-2.75

-1.29

1.00

2.07

7

-2.11

-1.06

1.00

1.87

8

-1.64

-0.87

1.00

1.70

9

-1.33

-0.70

1.00

1.54

10

-1.17

-0.54

1.00

1.38

11

-1.16

-0.37

1.00

1.19

12

-1.31

-0.19

2.17

2.39

13

-0.93

-0.21

1.92

2.13

14

-0.73

-0.22

1.85

2.07

15

-0.63

-0.21

1.88

2.09

16

-0.56

-0.21

1.95

2.15

17

-0.52

-0.20

2.04

2.23

18

-0.49

-0.19

2.13

2.31

19

-0.46

-0.18

2.22

2.39

20

-0.44

-0.17

2.31

2.47

Figure 8 compares the response of output (top-left panel), inflation
(top-right panel), the nominal interest rate (bottom-left panel)
and the real interest rate (bottom-right panel) to the crisis
without reforms (continuous black line) against the case of a
temporary reduction in labor and product market markups by one
percentage point (dashed blue line).

When monetary policy is constrained by the ZLB, temporary
reforms entail large output losses in the short-run. At the union
level, output drops by 7.4% on impact, almost doubling the output
costs associated with the crisis. As in the case of permanent
reforms, reducing markups increases the deflationary pressures
generated by the crisis. However, the temporary nature of the
reforms creates much more severe short-run deflationary pressures.
This result reflects two mechanisms. First, as in the case of
permanent reforms, lower prices increase the short-term real
interest rate. However, temporary reforms are associated with much
smaller wealth effects as long-run output is unchanged, thus
providing stronger incentives for agents to postpone their
consumption. Second, households understand that the eventual
unwinding of reforms (i.e. higher markups) when the crisis has
almost completely vanished will have inflationary consequences,
triggering a sharp increase in the nominal and real interest rate.
Anticipating the future tightening, aggregate demand contracts
immediately, contributing to a deeper crisis. This effect adds to
the initial deflationary pressures and creates a perverse feedback
loop, as the real interest rate further increases. Moreover, the
economy suffers a policy-induced double-dip recession when the ZLB
stops binding. Under temporary reforms, the absence of long-run
wealth effects together with higher short-run output losses imply
that, differently from the case of permanent reforms, the periphery
borrows from abroad and runs a current account deficit (not
shown).

In sum, our experiments suggest that when monetary policy is at
the ZLB, ambitious and credible structural reforms may have
undesirable short-run effects. In addition, when political economy
factors, such as electoral outcomes and social unrest, undermine
the credibility of the reforms and cast doubts on their
long-lasting impact, these perverse effects are likely to be
magnified.

5.4 Robustness

In this section, we briefly discuss the sensitivity of the
perverse effects of structural reforms at the ZLB to three factors,
namely the elasticity of intertemporal substitution, the size of
the economy implementing the reforms, and the nature of the shock
generating the crisis.17

Elasticity of Intertemporal Substitution. An important
parameter governing the short-run response of consumption to
changes in the real interest rate is the elasticity of
intertemporal substitution (
). As shown in Table 2, in our
benchmark calibration we set
, implying that the elasticity of
intertemporal substitution is above one Although
several authors provide evidence in support of our calibration
(Hansen and Singleton, 1983; Summers, 1984; Attanasio and Weber, 1989; Rotembert and Woodford, 1997; Gruber, 2006), other macroeconomists would consider
such a value for as a low estimate for this
parameter (Hall, 1988). Thus, given the
disagreement on the appropriate value for the elasticity of
intertemporal substitution in the literature, we repeat our
simulations with and .18 A smaller elasticity of
intertemporal substitution implies a smaller negative output effect
of permanent reforms in the short run. Moreover, and contrary to
our benchmark results, larger reforms lead to smaller output
losses. Yet, when , a permanent
reduction in labor and product markups by 10 percentage points (our
most ambitious reforms considered in Table 3) still leads to output
gains of only 0.6 percentage point relative to the crisis scenario.
Given the size of the reforms, these gains are quite small,
especially if compared to the 25% output increase experienced in
normal times, pointing once again to the critical role played by
(the lack of) monetary policy accommodation for the short-run
transmission of reforms.

Country Size. The effects of reforms during crisis times
are robust to changes in country size. Our calibration assumes that
the currency union consists of two equal-sized regions, which
represents a good approximation to the relative weight of core and
peripheral countries in the EMU.19 Our experiments
reflect the idea that all peripheral countries are currently being
encouraged to implement ambitious reform programs. In practice,
however, the implementation of reforms may occur at different times
in each country. To check if the size of the country that
implements the reforms matters for our results, we run simulations
assuming that the periphery country accounts for only 10% of
union-wide output.20

Perhaps not surprisingly, the main difference relative to the
symmetric case is the smaller output decline experienced by the
union as a whole. However, this difference simply reflects the
smaller weight of the periphery in aggregate variables. The
relevant real interest rate for the consumption decisions of the
representative household in the periphery is a function of the
nominal interest rate set by the common monetary authority, which
is at the ZLB during the crisis, and the periphery's CPI inflation
rate, which is approximately independent of the country
size.21 Structural reforms that make the
non-tradable sector in the periphery more competitive impact the
domestic CPI almost identically, no matter whether the periphery is
large or small. Therefore, the additional output contraction in the
periphery due to the reforms compared to the crisis scenario
remains essentially unaffected.

Asymmetric Shock. In our main experiment, we considered
the crisis as a shock that hits symmetrically both countries in the
currency union. However, the recovery from the global financial
crisis in core and peripheral European countries reveals a great
deal of asymmetry between the two regions, perhaps reflecting the
"macroeconomic imbalances" accumulated in the early 2000s.

Motivated by this observation, we investigate the robustness of
our main findings to a crisis shock that is not symmetric. We
consider a scenario where the shock only hits the periphery. As in
the previous exercise, we continue to calibrate the shock to match
a 4% decline in union-wide output. This crisis is still associated
with the nominal interest rate stuck at the ZLB for about three
years. We then study the effects of structural reforms implemented
in the periphery in the context of this crisis.

The main difference in case of an asymmetric shock is the large
adjustment in international variables. The periphery runs a large
current account surplus and the terms of trade significantly
contributes to the depreciation of the real exchange rate. However,
these movements primarily reflect the asymmetric nature of the
crisis shock and occur also in the absence of structural
reforms.

That said, structural reforms that permanently reduce product
and labor market markups in the periphery continue to be
contractionary in the short run, as more protracted deflation at
the ZLB results in higher real interest rates. With an asymmetric
crisis, the magnitudes of the additional output losses is
smaller--twenty basis points in the case of a 10 percentage points
reduction in markups. Yet, our main conclusion is qualitatively
unchanged.

6 Disentangling the Effects of Reforms
at the ZLB

So far, we have argued that the short-run transmission of
reforms depends critically on the ability of the central bank to
provide monetary policy accommodation. In normal times, the nominal
interest rate falls, providing stimulus against deflationary
pressures. However, in a severe crisis, whereby the central bank
runs into the ZLB constraint, the deflationary pressures associated
with structural reforms lead to higher real rates and further
depress economic activity. In this section, we consider two
experiments that shed light on the mechanism behind these
findings.

In the first experiment, which we label "New Deal," we assume
that the government sets
and
to temporarily increase the
monopolistic power of firms and unions. This experiment is in the
spirit of Eggertsson (2012), who claims that
policies of this kind contributed to end the Great Depression, or
can be interpreted as an application of unconventional fiscal
policies that provide monetary stimulus at the ZLB as in Correia et al. (2013).22 In essence, this policy aims at
generating expectations of price increases in the short run without
any implication for the long-run level of output. Thus, we
interpret this experiment as isolating the substitution effect
associated with expectations of higher prices at the ZLB.

In our simulations, the government increases distortionary taxes
on firms and workers as long as the "shadow" nominal interest
rate (i.e. the nominal interest rate absent the ZLB constraint)
stays in negative territory

where
is a parameter that
controls how aggressively the government increases the taxes in
response to the crisis.23

Our second experiment, which we label "Delay" , aims at
retaining the long-run benefits of structural reforms without
imposing the short-run costs in terms of deflation. Thus, we
interpret this experiment as isolating the wealth effect associated
with expectations of higher permanent income at the ZLB.

When the crisis hits, the government (credibly) announces that
it will implement structural reforms when the ZLB stops binding

The Delay rule differs from the New Deal rule because the permanent
change in the tax needs to be consistent with the final steady
state. Therefore, the coefficient
is constrained to be equal to
.

The idea that news about future supply increases may stimulate
subdued aggregate demand in an economy facing a liquidity trap is
not new. In their discussion about the Japanese ZLB experience of
the late 1990s, Krugman (1998) argues that an
expected drop in productivity due to population aging contributed
to the persistence of the ZLB, while Rogoff (1998) suggests that future productivity gains ought to be the solution to
the ZLB constraint. More recently, Fernandez-Villaverde et al. (2012) formalize this argument in a two-period New-Keynesian model. Our
Delay policy can be interpreted as a state-contingent application
of these arguments.

Figure 9 presents the response of the main variables to the New Deal policy
(dashed blue line) and to the Delay policy (dashed-dotted red
line). Notwithstanding the absence of monetary accommodation due to
the ZLB, both policies are closer to the short-run transmission
mechanism of reforms operating in normal times: On impact, output
in the currency union is well above the crisis scenario and, as a
consequence, the permanent reform scenario discussed in Section 5.2. Under the New
Deal policy, the initial drop in output is about 2.5%, much less
than the 4% contraction experienced in the absence of announced
reforms. Under the Delay policy, which is calibrated to a long-run
reduction in markups of 10 percentage points, the output gains are
somewhat larger (although still significantly less than in normal
times). In particular, output recovers from the crisis and monetary
policy exits the ZLB after only six quarters.

These experiments highlight the main tradeoffs associated with
the implementation of reforms at the ZLB. The New Deal policy
attempts to offset the deflationary effects of the crisis by
creating expectations for positive inflation through higher, albeit
temporary, monopoly power. Thus, this policy operates mainly
through the substitution effect of lower real interest rates and
has no effect on long-run income. In the case of the Delay policy,
the expectation that reforms will be permanent, though implemented
in the future, generates a large wealth effect that stimulates
aggregate demand, thus limiting the short-run output drop due to
the crisis and supporting domestic prices.

As for the open-economy variables, the permanent effects
associated with the Delay policy result in a gradual depreciation
of the real exchange rate and a current account surplus, similarly
to what was observed in normal times. The New Deal policy, in
contrast, has very little impact on international variables. The
temporary nature of this policy does not bring about any
realignment in international prices or permanent gain in
competitiveness. In the short-run, the real exchange rate modestly
appreciates and the current account turns slightly positive. These
responses reflect higher output and prices in the periphery
relative to the core, where no policy is implemented.

We close this section with an important caveat. The two policies
discussed in this section present serious political economy
challenges. Increasing markups in a crisis may combat deflationary
pressures, but the same interest groups that oppose permanent
reforms in a crisis could fight to make the temporary change indeed
permanent. Similarly, crises are times when external forces may
render unpleasant reforms acceptable. Announcing at the beginning
of a crisis that the ambitious reforms will be implemented when the
ZLB stops being binding poses obvious time-inconsistencies
problems. For these reasons, we interpret the "New Deal" and "Delay" policies as illustrative of the key mechanisms at play in
our model, rather than normative statements on the actual
implementation of structural reforms.

7 Conclusions

Structural reforms can greatly reduce the competitiveness gap
between the EMU core and periphery and boost income prospects in
the region. However, the timing of such reforms is crucial. If
undertaken during a crisis that takes monetary policy rates to the
ZLB, structural reforms can deepen the recession by worsening
deflation and increasing real rates. This effect becomes even
stronger if the public expects policymakers to later unwind these
reforms.

Our paper contributes to the recent literature on the
implications of the ZLB for the transmission of shocks. We expand
on the existing results by investigating the effects of permanent
markup changes at the ZLB in an open economy environment, thus
focusing on the domestic and international transmission of
shocks.

In addressing the effects of reforms at the ZLB, we have
abstracted from important considerations that are likely to shape
the policy debate in Europe. First, our analysis features only
inputs of production that cannot be accumulated over time. As
argued by Fernandez-Villaverde (2013) in his discussion of this
paper, the presence of physical capital may in principle preserve
the standard transmission mechanism of reforms. However, in their
simulations, Gavin et al. (2013) find that technology
shocks at the ZLB continue to have perverse effects, at least in a
closed economy environment. Moreover, if physical capital (or other
assets, such as housing) can relax borrowing limits through their
collateral value, perverse debt-deflation dynamics at the ZLB are
likely to be amplified (see, for instance, Eggertsson and Krugman, 2012). Second, while our analysis has
solely focused on the short-run transmission of reforms, the policy
debate in Europe involves important political economy
considerations (Blanchard adn Giavazzi, 2003). The
social and political opposition faced by governments in peripheral
Europe to adopt relatively small reform packages in times of
financial turbulence reveals the difficulties of changing these
policies in practice. Our findings emphasize a relevant
macroeconomic tradeoff associated with the absence of sufficient
monetary policy stimulus to support reform efforts. Future research
efforts could embed the pure macroeconomic forces discussed in this
paper in a political economy environment, with the objective of
drawing serious welfare implications.

Footnotes

1. Prepared for the 2013
Carnegie-NYU-Rochester Conference on "Fiscal Policy in the
Presence of Debt Crises." We thank our discussants Jesus
Fernadez-Villaverde, T. Braun, Anna Lipinska, and Ricardo M.
Félix for insightful comments, as well as seminar
participants at the Carnegie-NYU-Rochester Conference, the Federal
Reserve Bank of New York, the Federal Reserve Board, the University
of Maryland, the Spring 2013 SCIEA Meetings, the 2013 Midwest
Macroeconomic Meetings, the 2013 SED Meetings, the 2013 NBER Summer
Institute, the Central Bank of Hungary/CEPR/Bank of Italy
Conference on "Growth, Rebalancing, and Macroeconomic Adjustment
after Large Shocks," and King's College London. M. Henry Linder
provided excellent research assistance. The views in this paper are
solely the responsibility of the authors and should not be
interpreted as reflecting the view of the Board of Governors of the
Federal Reserve System or of any other person associated with the
Federal Reserve System. Return to
text

2. Corsetti and Pesaran (2012) note how
inflation differentials between EMU members and
Germany--effectively the rate of change of the real exchange
rate--are a much more reliable proxy for interest rate
differentials than sovereign debt-to-GDP differentials. To the
extent that current account deficits are correlated with real
exchange rate appreciations, the external balance of periphery
countries is also tightly related to sovereign yield spreads. In
sum, according to this view, fiscal and external imbalances, as
well as the relative competitive position, are different sides of
the same underlying problem (Eichengreen, 2010). Return to text

3. The product market efficiency index
is an average of the scores in the categories related to market
competition, such as "Extent of market dominance" and "Effectiveness of anti-monopoly policy." The labor market
efficiency index is an average of the scores in the categories
related to wage flexibility, such as "Flexibility in wage
determination" and "Redundancy costs in weeks of salary." See World Economic Forum (2012) for more details. Return to text

4.
OECD estimates of business markups and regulations burden paint a
similar picture. We make explicit use of these estimates in our
quantitative exercises. Return to
text

5. These large long-run gains are
consistent with the existing literature (Bayoumi et al., 2004; Forni et al., 2010), although the exact numbers
may be sensitive to the introduction of entry and exit in the
product market and search and matching frictions in the labor
market (Cacciatore and Fiori, 2012; Corsetti et al., 2013). Return to text

6. Cacciatore et al. (2012) study
optimal monetary policy in a monetary union under product and labor
market deregulation in a model with endogenous entry and exit and
search frictions. As in our "normal times" scenario, the Ramsey
plan in that setup also calls for monetary policy accommodation
during the transition period. Return to
text

7. In a small open economy calibrated to
Italian data, Gerali et al. (2013) find that strong
complementarities between structural reforms and fiscal
consolidations can give rise to substantial output benefits. Like
our experiments that temporarily increase markups or announce
reforms at later stages, however, political economy considerations
may hinder several aspects of such a coordinated plan and reduce
the combined gains of these supply-side policies. Return to text

8. When the ZLB does not bind, the AD
curve is horizontal in a zero-inflation targeting
regime. Return to text

9. Eggertsson (2010) calls this effect
the "paradox of toil." His analysis, however, is restricted to
temporary reforms, whereas our focus here is on the effects of
permanent reforms on the equilibrium. Return to text

10. We use the intermediation cost only
to ensure stationarity of the net foreign asset position. We set
the parameter small enough as to have no
discernible effects on the transition dynamics. Return to text

11. This definition is the
model-equivalent of the Harmonized Index of Consumer Prices (HICP),
the measure of consumer prices published by Eurostat. Return to text

12. We perform our simulations using
Dynare, which relies on a Newton-Rapson algorithm to compute
non-linear transitions between an initial point and the final
steady state. Return to text

14. The exact level of either the
inflation target or the bound on the interest rate is not central
for our results. What we need is that a lower bound for the policy
rate exists, thus preventing the monetary authority from providing
additional stimulus. To implement the zero-inflation targeting
regime in the simulations, we assume the policy reaction
function
where
is the feedback
coefficient on inflation and
is the effective lower bound
for the interest rate. A high enough value for
approximates a
zero-inflation targeting regime well. We set
, although higher values
would make no difference. Lower values can still approximate a
zero-inflation targeting in the model if we were to assume that the
ECB also responds to the output gap and/or the natural rate of
interest. Return to text

15. The real interest rate is high
relative to a counterfactual world in which the nominal interest
rate could go below its lower bound, and possibly into negative
territory. Return to text

16. These assumptions, while obviously
extreme, make the analysis particularly stark. More realistically,
the unwinding may occur with some probability at time of
implementation, which would likely lead to a smaller output drop.
At the same time, the unwinding may be decoupled from the duration
of the crisis--in particular, the reforms could be reversed a few
quarters after the ZLB stops being binding--which would entail more
severe output losses. Return to
text

17. Tables and figures associated with
these experiments are available upon request. Return to text

18. In each experiment, we recalibrate
the size of the preference shock to ensure that aggregate output
contracts 4% in the crisis episode. Return to text

19. In the data, Italy and Spain account
for 17% and 12% of euro-area output, respectively, whereas Greece,
Ireland, and Portugal each account for about 2% of total output.
Thus, peripheral countries account for about 35% of euro-area
output in total. Return to text

20. In this experiment, we adjust the
parameters governing home bias and the
share of tradable goods to match the same
targets as in the benchmark simulation. Return to text

21. Country size may have an indirect
effect on the domestic CPI via the terms of trade. Return to text

22. Given the severe fiscal constraints
faced by peripheral countries and the lack of exchange rate
flexibility, a recent academic literature (see Adao et al., 2009; Farhi et al., 2012) has focused on the scope
for fiscal devaluations, that is, revenue-neutral changes in the
composition of taxes that mimic an exchange rate devaluation.
However, quantitatively, the potential gains associated with these
policies for reasonable changes in tax rates appear to be limited
(Lipinska and von Thadden, 2012). Return to
text

23. We calibrate the parameter
in the New Deal policy to
minimize deflation on impact. Qualitatively, a constant increase in
taxes would achieve the same objective as the state-contingent
rule. However, if taxes remain high for too long, the nominal
interest rate may endogenously spike up even if the crisis is not
over yet. Return to text